Agency Theory and Corporate Collapse: the Girvan Case
The major principle
which ensures successful operation of financial markets is the availability of
information. The main sources of information about firms is their financial
statements. It is crucial that parties who demand information get accurate and
reliable documents. However, their quality may be affected by the clash of
interests between managers and owners which is known as agency theory. The
implications of conflicts on grounds of goals were observed in the case of
Girvan group. After years of mismanagement the company went bust. Another way
of presenting misleading information is the use of creative accounting, ie
tailoring statements to specific needs. The reasons of the collapse of Girvan
become obvious while analysing practices of creative accounting that were used
by the firm's management. Another tool of finding drawbacks in company's
financial documents is a relatively new concept of a cash flow statement. CFSs
enable analysts to trace the flow of cash in and out of the company over the
period of time. If operational cash flows, as they were in the Girvan's case,
are consistently negative, it is a sign that firm is not using efficiently its
assets and thus cannot recover enough cash throughout the business cycle.
Introduction 1. Agency Theory 1.1 Demand
and Supply of Financial Iinformation 1.2 Agency problem 2. Creative
Accounting 2.1 Analysis of Accounts and Notes 2.2 Cash Flow Analysis
present essay is aimed to discuss issues regarding problems that may arise in
terms of demand and supply of financial information. Based on the real life
example, the work deals with such questions as agency theory and creative
accounting and how they affect the financial statements. Special attention is
given to analysing the cash flow statement of the Girvan Corporation
reconstructed from the firm's funds statement and using other documents .
1. Agency Theory
1.1 Demand and Supply of Financial
One of the major principles of successful business
activity within the free market economy is the availability of information.
The efficient transfer of surplus money to deficit areas in order of obtaining
returns can happen only when potential investors have unfettered access to the
available data concerning the transaction. It includes all relevant
information about financial position of a firm that may affect investors'
decisions. Therefore, there's strong demand for true and correct information
from parties such as shareholders, investors, creditors, suppliers, government
authorities, market and security analysts and the like. The market thus,
forces businesses to supply information. The main sources of the information
are periodical financial statements. They may represent the current standing
of a firm (balance sheets) and more importantly, the summary of cash flows
which tells the level with which company efficiently handles its resources.
For different purposes, company (or more precisely, its management) may be
interested in presenting information which is not absolutely correct. Since,
in many cases, there are no strong, well-established and legally enforceable
standards regarding accounting procedures, the management may get involved in
altering accounts to their own need for a specific occasion (eg. applying for
a loan or paying taxes). In the case of Girvan Corporation, there was an
obvious attempt of supplying the market (the shareholders, creditors etc) with
misleading, distorted information. The cause of such misrepresentations is
often lies in the conflict of interests between different parties.
1.2 Agency Problem
The performance of any commercial
organisation may be affected by the clash of interests of the parties
involved. This is derived from the existence of difference in goals. It is
established that the ultimate goal of a business activity within the firm is
to maximise the wealth of its shareholders. However, the interpretation of
this postulate can vary significantly.
One of the main factors
affecting the performance of a company is that owners of listed companies are
separated from the management. Since managers are granted an enormous ability
to influence on the actions of a company, they may be tempted to commit
certain acts that go against the company's value (and hence shareholders'
wealth). Primarily, these are cases when managers are preoccupied solely with
maximising their own wealth. The clash between interests of managers and those
of the company, which leads to the decreasing value of the firm, is known as
agency theory. The ways to preventing such situations are market forces and
The constant monitoring of the market by big investors
and likelihood of being taken over by more successful competitors, stimulate
executives' desire to concentrate on maximising firm's value. Alternatively,
the agency problem may be solved by agency costs. They include monitoring,
bonding, opportunity and structuring expenditures. Such costs are directed to
monitoring the commitment of managers to behave in interests of shareholders,
foregoing their own enrichment at the expense of the company's value. The
conflicts of interest may arise involving other parties. For instance the
present shareholders vs potential shareholders. The shareholders may seek to
urge the management to do certain things which may undermine its market
stance, by way insisting on paying out the dividends, money which might be
needed to finance projects which will benefit the company's value in future.
In other words, firm may lose its potential (future) shareholders as a result
of actions of the present ones.
The frictions may arise between
creditors of a firm. For example, in case of a business' failure, its
unsecured creditors may claim the priority over the payment on outstanding
loans against the creditors who have some sort of security.
good example of conflict between goals is a lack of coincidence in interest
between a firm and government. The most obvious case is taxation, where
strategies of the parties are mutually exclusive. The company's benefit is
retaining as much profits as possible, whereas the government is concerned
with the increase of effectiveness of the tax collection.
In the case
of Girvan Corp., there was a clear cut case of the clash between goals of the
management and shareholders. The intentions of the company's managers pose
questions from the very beginning, ie the formation of the Girvan machine.
Girvan Corporation Ltd became listed when it was acquired by a small publicly
listed firm, Sift Securities Ltd which then changed the name to Girvan
Corporation Ltd. P.Petersen, executive chairman, has received 188.5 million
shares. The Girvan group consisted of the holding company Girvan Corp. Ltd,
Girvan Holdings Pty. Ltd and its subsidiary, the long-established construction
firm Girvan NSW Pty Ltd. The complex corporate structure was a major factor in
enabling managers to cover the company's poor performance over the time, which
has lead to the imminent collapse. Executives were aware of the firm's severe
cash flow problems, however, they continued to increase its indebtedness to
unsustainable levels. The result was that liabilities by January 1990 mounted
over assets at $650 million.
2. Creative Accounting 2.1 Analysis of
Accounts and Notes
Despite the existence of the accounting
conventions and standards there's a number of situations when the style of
presenting information is not strictly specified. It gives room for
rearranging accounts or altering procedures which may undermine the accuracy
and reliability of financial statements. One of the ways to discover accounts
that were "created" is a thorough analysis of notes to the accounts, provided
that they are themselves free from creativity., On the Girvan Corp. Ltd's
balance sheet of 30 June 1989 the net assets are shown at $193, 335, 000 ,
which is a good sign. Total current and non-current assets are $524.2 million
and $259.4 million respectively.
Analysing, however, the accounts,
reveals that the most substantial part of assets is current receivables,
$287.9 million. From the note 8 we see that the bulk of receivables are loans
to associated entities ($110.6 million) and other loans unsecured ($104.2
million). This suggests that huge amounts were shifted from one of the Group's
entities to another and that loans were not secured by any means. It's
important to notice that from 1988 to 1989 those accounts have increased in a
spectacular fashion. Loans to associated entities increased 8.7 times, from
$12.6 million to $110.6 million. Other loans - unsecured have jumped to the
amount of almost 31 (!) times higher than the year before, from $3.4 million
to $104.2 million. Trade debtors and short term deposits, in the meantime,
have decreased. Another account contributed to the overstatement of total
assets, was inventories (notes 10, 22) . Of $180.8 million total, $167.2
million were development properties - held for sale which were revaluations of
the previously current assets.
Significant portion of current assets
were investments, amounting to $31.6 million , the figure 25.6 times higher
than in the year 1988 ($1.2 million). The note to investments (9) discloses
that $30.3 million (96%) worth of the investments is account for shares in
associated entities, that is again, it shows the company has been transferring
funds to other entities within the group.
The analysis revealed that
the construction arm of the group Girvan NSW Pty Ltd performed work for
related entities without receiving cash payments. This subsidiary served a
role of treasury facilitating the flow of funds between the entities. For
instance, on the Girvan Corporation's balance sheet there was a decrease in
trade debtors (section current receivables, note 8) from $89.6 million to
$58.5 million. It was largely due to the transfer of $24.8 million from the
Girvan NSW Pty Ltd. The management used Girvan NSW Pty Ltd (established 1919)
as a tool of obtaining loans from banks. The cash then was redistributed
throughout the group thus distorting the picture of entities financial
positions. Such actions fall under the Accounting Standards section of
"Related Party Transaction" ASRB 1017, which requires disclosure of dealings
between parties where one of them is a significant shareholder in another, as
well as direct dealings with directors, including consultancy payments.
2.2 Cash Flow Analysis
A very good way to expose figures
in accounts which were derived creatively and other inconsistencies in
financial papers, is an analysis of cash flow statements. Following the
numerous corporate collapses in previous decades a doctrine of cash flow
statement (CFS) has been developed in the US in 1992 and later adopted
worldwide, including Australia. However, here as in much of Europe, CFSs have
not become mandatory.
Although CFSs are widely used today, there are
many firms in Australia exempted from presenting them. Sometimes they
construct Funds statements. Funds statements show summary of funds sources and
funds applications, where the former are defined as current assets less
Funds statements can be converted into CFSs. The
process lies in redefining funds from the sources section and their
applications into cash (or its equivalent) items. Firstly, funds from
operations figure* of 36,111 (#1) which is the difference of inflows and
outflows of funds from operations, appeared on Consolidated Summary of Sources
and Applications of Funds (note 38) is adjusted for unusual items such as sale
of non-current assets (#2).
3) Then adding 65,342, that is leases
expenses of 2,996 and interest 62, 347 (note 3) and other adjustments of
leases of 3,042 (#4) we obtain gross operating profit of 104,495 (#5).
Secondly, we calculate change in working investments, adding its
decrease or subtracting increase from the gross operating profit, ie:
6) we subtract the increase of stocks 1,028, note 10,
decrease in debtors of 30,905 , ie 89,898 less 58,993, note 20,
subtract increase in contracts of 8,980 (increase in contract retention 7,555
plus increase in prepayments and other debtors 1,425) note 38,
increase in creditors (trade creditors) 22,248 (86,720 less 64,472), note 14,
10) subtract decrease in other (unsecured) loans of 100,787 (104,186
less 3,399), note 8,
11) subtract increase in loans to associated
entities 97,956 (110,620 less 12,664), note 8, 12) subtract increase in
development properties 52,773 (176,235 less 114,462), note 10,
thus, from steps 6 to 12 we calculate change in working investment, in this
case it's increase of 208,371.
14) now adding back change in WI
-208,371(#13) to gross operating cash flow (#5) we get net operating cash flow
Thirdly, we calculate net cash flow after debt by
subtracting the following items from the net operating cash flow;
DEBT SERVICE 65,342 (2,996 plus 62,347), note 3;
16) lease expenses
3,042, note 12;
17) dividends paid 17,279, note 6;
term debt (current portion) 208,971: change in non-current bank loans secured
(256,390 less 47,837) of 208,533 plus change in unsecured loans 418 (13,000
less 12,582), note 14;
19) taxation paid 19,181, note 4;
adding items ##15 to 19 we obtain sub-total of 313,815 which, in turn is added
back to net operating cash flow to form -
21)- net cash flow after debt
service of minus 417,691.
Fourthly, we calculate non operating cash
needs by adding the following accounts, presented in the firm's funds
statement (note 38, page 64).
22) Other non-operating uses
/development properties/ 2,921.
28) Other long-term debtors + long term
due to's /increase in: term debtors 4,363 plus other loans 2,498 and deferred
expenditures 1,345 plus future income tax benefit in related company acquired
29) intangibles, 107; current shares, 30,398 /increase in
current shares in other corporations and shares in associated entities, 31,628
less 1,230/, note 9.
30) Thus adding 22 to 29 we have minus 182,126 in
non operating cash needs.
31) Adding back non operating cash needs to
net cash flow after debt service we obtain total cash needs before
Fifthly, we calculate non-operating sources by adding other
sources of funds (from the funds statement, note 38) that come from activities
other than operations;
32) loans to associates 11,735 (decrease in:
loans to associated entities 11,551 plus 4 in lease receivable and 180 in
provisions in related companies acquired) and other non operating sources -
short term debt 259,469. 34) increase in equity /proceeds from share issues/
6,127 . 35) increase in long-term debt 8,269 /increase in foreign currency
translation reserve, 134 plus increase in liability in respect of capitalised
36) long term convertible notes- nil.
proceeds from sale of investments /decrease in investment properties/ 291,940.
38) minorities /minority interest in subsidiary companies acquired/
39) adding figures 32-39 we obtain total non operating sources
Sixthly and finally, we add the last figure to the
negative number of total cash needs before financing and the result will be
NET MOVEMENT IN CASH AND MARKETABLE SECURITIES (#40). The figure is negative
7,580. It means that there's negative cash flow of $7.58 million.
consistent negative figure for the operational cash flow suggests that a
company does not generate enough funds by using its assets. The fact should
then be a warning to responsible management that a company needs overhaul in
its strategy with which it uses assets, in order to achieve necessary levels
The consistently high negative
operational cash flows of the Girvan companies up to $5 million per week and
the continuous rise in debt has lead to the final collapse. Having raised $200
million from the public in September 1987 the firm chronic drain of funds. The
creative accounting helped to hide the real position of the company, large by
virtue of transferring money from one entity of the group to another. In the
end (by January 1990), enormous deficiency of cash inflows to outflows has
lead to liabilities mounting over assets at about $650 million.
Bartholdy, J. Glenn W.
"Corporate capital structure and regulation of bank equity holdings:
international evidence", Multinational Finance Journal, v1(1), 1997 Mar,
Freedman W. "Fortunes in footnotes", Chemical Week, vol.158
(34), 1996 Sep, pp.27-30
Hussey, R. Ong A. "Creative accounting- do
numbers reveal the whole picture?", Credit Control, vol. 17 (10), 1996,
Pottier, St. Sommer, D. "Agency theory and life insurer
ownership structure", Journal of Risk & Insurance, v.64 (3), 1997 Sep.,
Preston, L. "Agents, stewards, and stakeholders", Academy
of Management Review, v.23 (1), 1998 Jan, p.9
Stickney, C. "Financial
Reporting and Statement Analysis", 3d ediion,The Dryden Press, 1996.
Walker, Matthew A. "The agency problem and the management of
closed-end funds: Managerialism and its impact on expense ratios", Journal of
Managerial Issues, Vol. 9 (4), 1997 winter, pp.485-496
Gomez-Meija, L. "A behavioral agency model of managerial risk taking", Academy
of Management Review, v.23 (1), 1998 Jan, pp.133-153